Illegal lenders are siphoning money from state-owned banks, but they may do more good than harm

Ye Sheng, who runs a luggage parts-manufacturing company in China's eastern Zhejiang province, is an unlikely looking banker. He doesn't wear three-piece suits, and his place of business rings with the shouts and banter of hundreds of workers who screw steel wheels to the bottom of satchels bound for department stores in South Korea. But Ye is a moneylender all the same. To keep his company in cash, he has taken in $10,000 in deposits from family and friends. He pays them interest, uses their money as working capital, and occasionally he extends loans to other private companies. "I give better returns than banks, and people trust me just as much," he says.

Although Ye's activities are technically illegal, they are an entrenched part of the economic ecology in China's capitalistic enclaves. Zhejiang, which has since the late 1980s been at the front line of free enterprise, is home to tens of thousands of private companies. Although these independents fuel most of the area's economic growth and provide most of the jobs, they usually are shut out from borrowing by China's four big state-owned banks, which typically ignore small private ventures. So when entrepreneurs need capital, they turn to "shadow" banks—China's vast, flourishing gray market of unregulated lenders, including companies run by people like Ye, associations made up of citizens who pool their savings to invest and to lend among themselves, and informal lending between firms.

It's difficult to ascertain how widespread shadow banking is throughout China. Beijing University economist Shen Minggao estimates that two-thirds of all financial activity in Zhejiang takes place outside the formal banking system. Local regulators do nothing to discourage informal lending because it funnels capital to vital, fast-growing businesses. But national economic conditions could now make it more difficult to look the other way. For one thing, China's inflation rate has crept above 5% while interest on savings deposits remains about 2%. In other words, Chinese lose money when they park cash in legitimate banks. It now appears that savers in Zhejiang, who have few legal investment options, are lending their cash directly to friends or are turning more of their nest eggs over to people like Ye, who pays higher interest rates than banks. Government figures show that depositors in Wenzhou—the financial heart of Zhejiang province—have withdrawn at least $1.2 billion in bank savings since February, according to the city's branch of the China Banking Regulatory Commission (CBRC).

These mass withdrawals pose a direct, albeit somewhat nebulous, threat to China's legitimate (but often poorly managed) lenders, which are burdened by bad loans to state enterprises and depend heavily on the deposits of ordinary Chinese to remain solvent. If the rest of the country follows Zhejiang's example, the deposit exodus could shake confidence in the entire system, sparking bank runs and a financial crisis. Arthur Kroeber, managing editor of the Beijing-based China Economic Quarterly, says the main reason the government increased interest rates last month by 0.27% for one-year loans and deposits—China's first rate hike in nine years—was to encourage people to keep their cash in banks. More interest-rate increases are expected, especially if inflation continues to gather steam.

A run on banks remains unlikely, but shadow banking poses another problem to Beijing. China's technocrats are trying to slow the country's unsustainably high growth rates partly by curtailing lending. But financial czars have no control over money sloshing around in unregulated banking networks, making it difficult to enforce curbs. Illegal funds have defied the government by investing in overheated sectors such as real estate. State-run media blamed "wandering ghouls" from Wenzhou for driving up property prices in Shanghai last summer.

In the past, Beijing might have responded by cracking down and throwing a few people in jail for loan sharking. That hasn't happened for the simple reason that the gray-market provides an efficient means of capital allocation in ways the country's socialist-era financial system cannot. The People's Bank of China, the central bank, discovered this recently when it started monitoring gray-market capital flows in Zhejiang. Expecting to find shadow bankers charging exorbitant rates, they instead discovered that underground interest rates were only marginally higher than what banks offer and repayment terms were better. This steady source of finance has given Zhejiang not only China's most vibrant private economy but also the lowest level of nonperforming bank loans in the country. Permitting informal lending allows state-run banks, which provide most of their loans to state-owned enterprises, to "focus on bigger, reliable companies, [while] smaller ones finance themselves in other ways," says Bao Sihu, head of the CBRC in Yuhuan county, home to dozens of private factories specializing in valves.

The most common source of funding in Zhejiang comes from investment pools, called hui, run by people like Xu Shoucong. This past March, Xu's family organized 17 people to create a fund that rotates credit to all participants, who use the cash for anything from weddings to starting small businesses. Huis loosely resemble microfinance schemes of the kind made famous by the Grameen Bank in Bangladesh, and millions of people participate in Zhejiang and neighboring Fujian province. Because the pressure to repay derives from social networks that are as strong as rebar in Confucian China, borrowers rarely default. In the past, Xu has used his hui money to invest in a relative's clothing store and to redecorate his $12-per-night inn.

Informal finance isn't just for mom-and-pop shops. Wenzhou's biggest restaurant, the 200-table Golden Fields Village, opened in May and specializes in shark-fin soup, giant snails and stingrays. Owner Wu Jianguan started the business by borrowing $100,000 from banks by mortgaging his home. But that wasn't enough to pay for the floor-to-ceiling fish tanks and staff of 150 hostesses in purple evening gowns, so he borrowed five times more from friends at higher rates. The cornerstones of such informal lending are relationships far stronger than Wu's connections to the bank. "If the bank repossesses my home, I'll have nowhere to live but I can still do business," he says. "But if I fail to repay my friends, I'll never do business in this town again."

Of course, the government must guard against Ponzi schemes and pyramid scams. On occasion, several huis will pool their money, and one failure will lead to a series of them. In September last year, just such a structure collapsed in Zhejiang's Fenghua city, according to Oriental Outlook magazine, and the hui leaders were forced to flee.

Yet on the whole, the government has turned a benevolent eye toward illicit finance. Cracking down would be "like taking seed grain away from farmers," says Beijing University's Shen. Gray-market lending is even providing inspiration for a new generation of would-be private bankers. A group of scholars at Zhejiang's Communist Party School, a training ground for cadres, are proposing to "establish legal private banks" along the lines of underground institutions, according to one of the professors who helped draft the proposal.

The trick for China now is "to regulate private capital without cutting off funding sources for healthy private companies," says Karin Finkelston, China representative of the International Finance Corporation, the World Bank's private-finance arm. And increasingly, Beijing has been welcoming private capital that it barred in the past. In June, regulators approved the country's first two private-investment funds. Both plan to invest several hundred million dollars raised from private firms in Wenzhou. Such funds are still barred from lending, but managers expect approval in the future.

Beijing has even made Zhejiang's healthy government-run banking system, which lends heavily to private companies, into a national model. Wenzhou was the first city to allow banks to ignore government caps and lend at whatever rate the market would bear. Higher rates meant the banks were better rewarded for the risks of lending to small job-creating firms. On Oct. 28, Beijing finally granted the same right to all of the country's banks. The city of Taizhou even has China's first fully private bank, the Taizhou City Commercial Bank. Regulators have refused to approve it but, significantly, haven't shut it down either. "These small banks don't issue loans based on government directives, so their investment is much healthier," explains Shi Jinchuan, an expert on underground finance at Zhejiang University.

As China's socialist-era financial system continues to make the transition to capitalism, shadow bankers may prove to be less of a threat to the system and more of an ally. The CBRC "at first treated us like ugly babies," says Wang Zhentao, vice chairman of the new investment company Zhong Rui. "Now we're growing up." The sooner the rest of the country's beleaguered banking system follows suit, the better.